The American Jobs Creation Act of 2004 enacted Code Sec. 409A, which requires the current inclusion in income of deferred compensation that does not meet the new, more stringent requirements of Code Sec. 409A.

The new provision is effective with respect to amounts deferred after Dec. 31, 2004, and with respect to amounts deferred in tax years beginning before Jan. 1, 2005, if the plan under which the deferral is made is materially modified after Oct. 3, 2004. The provision is therefore fully in effect for 2005 deferrals.

In order to provide rapid guidance to taxpayers seeking to comply with the new Code Sec. 409A requirements, and also to comply with a congressional directive that guidance be issued within 60 days of the enactment of the legislation, the Treasury Department and the Internal Revenue Service issued Notice 2005-1 in late December 2004. Notice 2005-1 is intended as preliminary guidance to get taxpayers through 2005. The notice is described as the first part of what is expected to be a series of guidance on the issue. The notice also makes a number of interpretations favorable to taxpayers, while warning that subsequent guidance may well tighten up on some of these interpretations, but only on a prospective basis.

Notice 2005-1 addresses a number of issues in question-and-answer format, focusing on definitions and coverage, the treatment of non-statutory stock options and stock appreciation rights, change-in-control events, acceleration of payments, effective dates and transition relief, and information reporting and wage withholding requirements. The notice does not cover in any overall sense Code Sec. 409A requirements with respect to the timing of deferral elections and distributions, although certain specific issues are addressed.

Notice 2005-1 is, on the whole, good news for taxpayers, providing a period of flexibility and transition relief as companies and their employees adapt to the new requirements of Code Sec. 409A. Taxpayers and their advisors will want to take full advantage of this time to review their nonqualified deferred compensation plans to adjust to the new realities.

Definitions and exceptions

Notice 2005-1 defines a nonqualified deferred compensation plan as any plan that provides for the deferral of compensation, extending not just to employer/employee relationships, but also to partnership/partner relationships, as well as independent contractor relationships.

Excepted from this definition are qualified employers plans and certain welfare benefit plans. Another important exception to this definition relates to short-term deferrals, where the plan requires that amounts be paid out within a short period of time once the amounts are fully earned and vested.

While incentive and nonstatutory stock options, stock appreciation rights, and other equity- based compensation will generally be viewed as nonqualified deferred compensation, Notice 2005-1 specifies the criteria under which these forms of compensation will not constitute deferred compensation.

In addition to defining nonqualified deferred compensation, Notice 2005-1 also defines the terms "service provider" and "service recipient," and what constitutes a "plan" and a "substantial risk of forfeiture." Excepted from the definition of a service provider are arrangements between accrual-basis taxpayers and arrangements involving substantial services provided to more than one unrelated service recipient.

Change in control events

Code Sec. 409A permits distributions from nonqualified deferred compensation plans only upon certain specified events: separation from service, disability, death, unforeseeable emergency, a time specified under the plan at the date of deferral, and change in ownership or control. However, a change in control of the corporation is one of the few events that is qualified by "the extent provided by the Secretary."

Notice 2005-1 addresses what is required to constitute a change of ownership, what is required to constitute a change in effective control, and what is required to constitute a change in the ownership of a substantial portion of the assets of a corporation.

For a change of ownership or control to occur, the change must occur to the corporation that receives the services of the service provider receiving the compensation, or a corporation that is liable for payment of the compensation or a corporation owning such a corporation.

The notice does not address changes in control of non-corporate entities.

Acceleration of payments

Code Sec. 409A in general prohibits any acceleration of payments. Notice 2005-1 provides that a waiver or acceleration of the satisfaction of a condition constituting a substantial risk of forfeiture is not an acceleration, even if the earlier expiration of the substantial risk of forfeiture permits an earlier distribution.

Also, amending a plan to permit the early distribution of de minimis amounts is allowed. Accelerations are also permitted to comply with domestic relations orders, as necessary to comply with federal conflicts-of-interest divestiture requirements for federal office holders, and to permit payment of employment taxes.

Distributions that are triggered by disability, death or an unforeseeable emergency are not considered accelerated payments, but rather a legitimate reason for distribution.

Transition guidance

Notice 2005-1 addresses the calculation of compensation deferred before Jan. 1, 2005, and when a plan is materially modified. A key statement in the notice provides that nonqualified deferred compensation plans adopted before Dec. 31, 2005, will not be treated as violating Code Sec. 409A if the plan is operated in good faith compliance with its provisions and Notice 2005-1 during calendar year 2005, and the plan is amended on or before Dec. 31, 2005, to conform to the provisions of Code Sec. 409A with respect to any amounts subject to its provisions.

This takes some pressure off any requirement to rapidly amend plans, but still requires taxpayers to become familiar enough with Code Sec. 409A requirements to be able to exercise a good faith, reasonable interpretation of its requirements throughout the year.

Among the guidance included is the determination of when a plan is materially modified; the conditions under which a plan adopted before Dec. 31, 2005, may be operated and amended; when deferral elections on or before Dec. 31, 2005, will be exempt from the timing-of-elections requirements; the conditions under which deferral elections may be made with respect to bonus compensation; and the circumstances under which payments will be permitted based upon elections for periods ending on or before Dec. 31, 2005.

One important transition rule is that a plan may treat different service providers differently. A plan adopted before Dec. 31, 2005, may be amended to allow a participant during all or part of calendar year 2005 to eliminate participation in the plan or cancel a deferral election without causing the plan to fail to conform to the provisions of Code Sec. 409A.

Reporting and withholding

Notice 2005-1 does not address specific methods for calculating the amount of deferrals or the amounts includible in gross income and as wages. Those issues are anticipated to be addressed in guidance later in 2005. Notice 2005-1 does include some interim guidance addressing an employer's withholding and reporting obligations to cover situations in which the employer must furnish an expedited W-2 during 2005 before that additional guidance is issued.


Notice 2005-1 effectively makes 2005 a transition year. Taxpayers are given until the end of the year to adopt and modify plans to comply with Code Sec. 409A. During 2005, they are required to exercise good faith and reasonable judgment in applying Code Sec. 409A requirements to deferral decisions.

In fact, it will in general be advisable to wait until near the end of the year to adopt and modify plans to gain the benefit of further guidance issued during the course of the year.

Notice 2005-1 may provide many of the answers that taxpayers and their advisors need in the interim. Already, however, many taxpayers are asking the Treasury to address additional issues not covered by Notice 2005-1. The Treasury and the IRS have indicated, however, that future guidance may not be a liberal as the guidance set forth in Notice 2005-1.

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